Why Wall Street Abandoned Partnerships

One popular theory about what went wrong with Wall Street points the finger squarely at the transformation of investment banks from private partnerships into publicly held companies. What few people understand is that this transformation wasn’t the result of unchecked market processes, unmitigated greed or deregulation—it was largely the result of regulation.

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The transformation got underway when Donaldson,Lufkin & Jenrette went public in 1970. It was the first New York Stock Exchange member to offer shares to the public, something that was actually against the exchange’s rules when DLJ proposed to do it.

Merrill Lynch went public a year later in 1971. Lehman Brothers arguably was next when it was acquired by the publicly listed Shearson/American Express in 1984, although it would be another decade before Lehman was listed on its own. Bear Stearns went public in 1985. Morgan Stanley followed in 1986. Goldman Sachs maintained its partnership structure until1999.

The Gang of Five went public so they could compete with the international banking giants that were encroaching on their core business of underwriting stock offerings and advising firms and so they could boost their activities in risky, capital-intensive businesses like proprietary trading. "In order to have a capital base that would support the funding they needed, they had to be public," says Roy Smith, a former Goldman Sachs partner and a professor of finance at New York University.

So was it capitalism that ruined partnerships? Not quite.

What the Capitalism Theory overlooks is that the need for a permanent capital base was not something that arose out of the marketplace—it arose out of an act of legislation followed by a series of regulations passed by the SEC. That act of legislation did not direct Wall Street firms to give up their partnership structure—but it had that effect, albeit over a long period of time.

In the late 1960s, Wall Street was going through what became known as “The Paperwork Crisis.” A huge surge in trading volumes throughout the 1960s had overwhelmed Wall Street. Unable to keep up with the volume, brokerages saw their record-keeping and trade-processing breakdown.

They failed to make customer trades, errors became rampant, fraud and outright theft of securities flourished.

In reaction to this, the NYSE and other exchanges, agreed with the SEC to curtail trading hours. During one period, the NYSE would shut down every Wednesday to allow member firms to get their books in order.

The NASD urged its members to cut back on their business. The SEC gave similar orders to firms it considered the most troubled.

Not surprisingly—with firms cutting back on their business and trading hours constrained—trading volume dropped off badly. By 1969, Wall Street was in a deep slump. Over 160 member firms of the NYSE went out of business. Many more survived only by merging with rivals. The regulatory response to the Paperwork Crisis had prompted a solvency crisis on Wall Street.

Congress responded in a way that might seem familiar to contemporary readers—it passed a bailout bill. In April of 1970, Senator Edmund Muskie introduced the first version of a bill that he said would “restore investor confidence and help securities markets to flourish.”

The bill was passed eight months later as the Securities Investor Protection Act.

SIPA, as it is known, created a reserve fund to provide financial protection to investors if their broker ran into financial trouble. Of course, doing this also provided financial protection to the brokers—they no longer needed to fear customers suddenly fleeing for fears of a brokerage insolvency. Of course, this is the perfect recipe for creating moral hazard—encouraging excessive risk-taking by firms no longer worried about being disciplined by their clients.

To combat moral hazard, SIPA authorized the SEC to create capital requirements for Wall Street brokerages. The capital rules the SEC promulgated required firms to maintain specified levels of net liquid assets as a ratio of obligations to customers and creditors. This rule created the need for new capital on Wall Street. As the firms began to grow again, especially in the 1980s, they found it was impossible to raise the required capital through the partnership structure. The only alternative was the public market.

That is how Wall Street began the long journey away from partnerships toward publicly held corporations on Wall Street. It wasn’t capitalism—it was the regulation of capitalism that sparked the transformation.